Why Are Big Banks Going To War With A Federal Judge?

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The nation’s largest banks have devised a novel way to protect their interests and save themselves from hundreds of billions of dollars in legal exposure. They’re taking a judge to court.

Lawyers for 17 banks submitted an unusual filing in the Second Circuit Court of Appeals this week (just listing all the corporate lawyers involved takes up the first four pages). The banks – including JPMorgan Chase, Bank of America, Wells Fargo, Goldman Sachs, Citigroup and Morgan Stanley – stand accused of ripping off the mortgage giants Fannie Mae and Freddie Mac. The Federal Housing Finance Agency, Fannie and Freddie’s conservator, alleges that these banks improperly sold $200 billion worth of mortgage-backed securities without disclosing the shoddy underwriting of the underlying loans. FHFA argues the banks knew the loans in the securities were bad, yet sold them to Fannie and Freddie anyway, leading to massive losses and the need for a government bailout. So FHFA wants the banks to buy back the securities they improperly sold under false pretenses.

U.S. District Court Judge Denise Cote took over the case in December, 2011, and quickly made a series of rulings in the case, first denying a motion by the banks to dismiss the lawsuit. The bank lawyers have become so dissatisfied with Cote’s rulings, in fact, that they have asked the Second Circuit to reverse them. The filing calls for a “writ of mandamus” that would throw out a series of rulings around discovery, which the bank lawyers claim “deprived Petitioners of their right to obtain evidence.” (You can chew for a moment on the idea that banks are being deprived of their rights.)

Specifically, the banks want access to evidence on a separate unit of Fannie and Freddie’s business that stands apart from the traders who purchased the mortgage-backed securities. They want to raise the limit of depositions of the plaintiffs in the case – questions for executives at the FHFA, Fannie Mae and Freddie Mac – from 20 to 400. They want the judge to lower the threshold for relevance to collect evidence on the specific claims of fraud and punitive damages. All of these efforts by the banks would significantly lengthen the discovery phase of the trial, and could represent a fishing expedition, with the lawyers trying every tactic to muddy the core issues in the case.

What’s really surprising is that the banks would try to go over the head of Judge Cote, who will eventually have to preside over the case. Normally you wouldn’t try so hard to piss off a presiding judge and get a higher court to reverse her rulings. In the filing, the banks take pains to call Judge Cote “an experienced jurist,” but say that they simply must seek the writ of mandamus because of her “gravely prejudicial rulings.”

What’s really going on here? The banks are frightened about their legal exposure. A loss at trial would lead to a multi-billion-dollar payout to FHFA. But even a cash settlement (which the banks claim Judge Cote, by her rulings, is trying to coerce) would likely trigger a wave of private litigation. Every investor who ever bought a mortgage-backed security would have a roadmap for recouping losses. Large banks are already on the hook for $100 billion in legal costs from their actions during the financial crisis. An adverse ruling in the FHFA case, and those costs would rise much higher.

This weighs on the banks’ stock prices, as investors steer clear of entities absorbing billions in losses every quarter. They want to limit their obligations wherever possible. And if that means suing a judge, so be it.